Charts - Moving Average Flavors

While most moving averages (MAs) take the closing prices of a given asset and factor them into the calculation, this does not always need to be the case. It is possible to calculate a moving average by using the open, close, high, low or even the median. Even though there is little difference between these calculations when plotted on a chart, the slight difference could still impact your analysis.

Finding Appropriate Time PeriodsBecause most MAs represent the average of all the applicable daily prices, it should be noted that the time frame does not always need to be in days. Moving averages can also be calculated using minutes, hours, weeks, months, quarters, years etc. Why would a forex day trader care about how a 50-day moving average will affect the price over the upcoming weeks? Rather, a day trader would want to pay attention to a 50-minute average to get an idea of the relative cost of the security compared to the past hour.

No Average Is FoolproofAs you know, nothing in the forex markets is guaranteed - especially when it comes to using technical indicators. If a currency pair bounced off the support of a major average every time it came close, we would all be rich. One of the major disadvantages of using moving averages is that they are relatively useless when an asset is trending sideways, compared to the times when a strong trend is present. As you can see in Figure 1, the price of an asset can pass through a moving average many times when the trend is moving sideways, making it difficult to decide how to trade.

Figure 1

Source: MetaStock

Responsiveness to Price ActionTraders who use moving averages in their trading will quickly admit that there is a battle between trying to make a moving average responsive to changes in trend while not allowing it to be so sensitive that it causes a trader to prematurely enter or exit a position. Because the quality of the transaction signals can vary drastically depending on the time periods used in the calculation, it is highly recommended that traders look at other technical indicators for confirmation of any move predicted by a moving average. (For more on various indicators, see Introduction To Technical Analysis.)

Beware of the LagBecause moving averages are a lagging indicator, transaction signals will always occur after the price has moved enough in one direction to cause the moving average to respond. This lagging characteristic can often work against a trader and cause him or her to enter into a position at the least opportune time. One major problem that regularly arises is that the price may have already experienced a large increase before the transaction signal is emerges. As you can see in Figure 2, the large price gap creates a buy signal in late August, but this signal is too late because the price has already moved up by more than 25% over the past 12 days and is becoming exhausted. In this case, the lagging aspect of a moving average would work against the trader and likely result in a losing trade.

Figure 2

Source: MetaStock

Moving Average Convergence Divergence (MACD)One of the most popular technical indicators, the moving average convergence divergence (MACD), is used by traders to monitor the relationship between two moving averages. It is generally calculated by subtracting a 26-day exponential moving average from a 12-day EMA. When the MACD has a positive value, the short-term average is located above the long-term average. This stacking order of the averages is an indication of upward momentum. A negative value occurs when the short-term average is below the long-term average - a sign that the current momentum is in the downward direction. Many traders will also watch for a move above or below the zero line because this signals the position where the two averages are equal (crossover strategy applies here). A move above zero is used as a buy sign, while a cross below zero can be used as a sell signal. (For more on this, read Moving Average Convergence Divergence - Part 1 and Part 2.)

Signal/Trigger LineMoving averages can be created for any form of data that changes frequently. It is possible to take a moving average of a technical indicator such as the MACD. For example, a nine-period EMA of the MACD values is added to the chart in Figure 1 in an attempt to form transaction signals. As you can see, buy signals are generated when the value of the indicator crosses above the signal line (dotted line), while short signals are generated from a cross below the signal line. It is important to note that regardless of the indicator being used, a move beyond a signal line is interpreted in the same manner; the only thing that varies is the number of time periods used to create it.

Figure 3

Source: MetaStock

Bollinger Band®A Bollinger Band® technical indicator looks similar to the moving average envelope, but differs in how the outer bands are created. The bands of this indicator are generally placed two standard deviations away from a simple moving average. In general, a move toward the upper band can often suggest that the asset is becoming overbought, while a move close to the lower band can suggest the asset is becoming oversold. The tightening of the bands is often used by traders as an early indication that overall volatility is about to increase and that a trader may want to wait for a sharp price move. (For further reading, check out The Basics Of Bollinger Bands® and our Technical Analysis tutorial.)